Tuesday, September 21, 2010

The Fed is Awakening From Its Slumber

You may have missed it, but this afternoon a slumbering giant with a formidable arsenal of economic weapons began to awake. That giant is the Fed and its formidable arsenal is its ability to further expand its balance sheet and shape nominal expectations. Though the Fed did not fully awake today, it showed signs of awareness that have been absent in the past few months. Specifically, this excerpt from the FOMC press release reveals the Fed is becoming more concerned about the low levels of inflation:

Measures of underlying inflation are currently at levels somewhat below those the Committee judges most consistent, over the longer run, with its mandate to promote maximum employment and price stability. With substantial resource slack continuing to restrain cost pressures and longer-term inflation expectations stable, inflation is likely to remain subdued for some time before rising to levels the Committee considers consistent with its mandate.

The Fed is finally getting concerned that inflation--a symptom of aggregate spending--is not where it should be. As Colin Barr notes, this is the Fed's first explicit acknowledgment of this worrying development and it implies the Fed is one step closer to a further loosening of monetary policy. Ryan Avent agrees on this point.

So the slumbering giant is awakening. However, there seems to be quite a bit more awakening to do because the excerpt above claims that "long-term inflation expectations are stable." Take a real close look at my previous post. Using different measures, this post shows that long-term inflation expectations are not stable. This part of the statement leaves me puzzled.

Overall, though, this is an improvement over the outcome from the last FOMC meeting. Maybe Santa Claus Bernanke will grant me my Christmas wish after all.

Update: A number of Wall Street economists also view this statement as a step closer toward further monetary easing. It will be interesting to see if the market via changes in expected inflation, value of the dollar, and other asset prices agrees.

9 comments:

Excellent post. Keep up the good work. BTW, for some reason, the media always uses the words "massive" and "trillion-dollar" to discuss QE. Scott Sumner has outlined a very workable plan, in which the Fed starts at $100 billion a month in QE. You may wish to devote a post to debunkiong the mondset that the Fed only has huge A-bombs in arsenal. In fact, the Fed also has tactical nukes (excuse the horrible and perhaps inaccurate analogies).

Gavyn Davies notes in the FT today that core PCE is about where it was in 2003. Yet you criticised them for being too inflationary back then!This is not a critique of you so much as a warning that we really are over our heads here in making policy recommendations. Nobody really knows. And Hayek would say, haven't we been here before? (see, Nobel speech, 1974, pretense of knowledge). One can just as easily make justifiable statements that the Fed should now be raising rates -as Ragu Rajan has done.

That is why I really don't like even making a case based on the inflation rate. It is, after all , just an underlying symptom of AD and AS shocks. However, I do think today one can clearly point to weak AD versus strong AS in 2003 as the source of the low inflation rate.

But I will confess that I am often torn about the potential long-run unknowns about further monetary easing. For example, I just read the other day about how pension funds are having a hard time staying fully funded because of the low interest rates. And then there is the fact that Fed's monetary policies are getting exported to the rest of the world. So I guess I am invoking some "Fatal Conceit" here and assuming on balance more easing is good.

FED´s been planning this awakening of economy before month. But this day with big "D" is here. CEO of FED Ben Bernanke´ll hope that new financial injection help to support the next grow of american economy. But some sceptics assumed this FED´s step will not be prosperous. We will see in two following months.

DB: Yes, and the current nightmare makes teaching Kydland&Prescott's time-consistency model so much more immediate for students than dusty old history from the early 80s!

Short-term benefit of low interest rates but long-term cost of raising probability of future financial crisis with yet more taxpayer cost. A classic sub-optimal policy that we have fallen into - AGAIN!

David- I always find your Fed "Superpower" status comments, such as the one to ECB above, intriguing. But I don't have a sense of quite what you see as the overall implications for Fed policy and the Bretton Woods II system.

My strong impression is that it is essentially not a good thing. Clearly, the legal mandate of the Fed is not designed to take thses factors into account (not that the Fed seems to feel constrained by the dual mandate). What are the options, accept the Superpower role and give up monetary sovereignty or print USD until the world doesn't want to hold them as reserves?

I agree the Fed's influence over global monetary conditions is not optimal. Until the Dollar Block countries quit pegging to the U.S. dollar, I am not sure that the Fed can do anything about it. It could at least acknowledge it has such an influence and consider the implications.

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About Me

I am an assistant professor of economics at Western Kentucky University in Bowling Green, Kentucky. I am using this blog as an outlet to express my ideas, concerns, and questions on macroeconomics and markets.